A Tax to Kill High Frequency Trading

As the British experience with the stamp duty demonstrates, a FTT is easily collected at the clearinghouse level. Collection is guaranteed by British law’s refusal to recognize the transfer if stamp duty has not been paid. Stamp duty is also collected on foreign trades of depository receipts of British companies.

High-frequency trading. A low-rate FTT could kill off HFT quickly and easily by wiping out HFT’s thin profit margins. The typical HFT spread is less than one basis point.

HFT now accounts for roughly 60 percent of trading in U.S. equity markets—it is fair to say that HFT is the market. HFT is expanding into currency trading, bond trading and foreign equity markets.

HFT is computer-generated front running. It ought to be illegal, but the SEC is too timid to kill it. Yes, front running is already illegal, and yes, the SEC has slapped a few wrists about preferential access to order data. But the tiny fines show that the SEC cannot be trusted to put the interests of investors ahead of those of traders and exchanges.

HFT has been facilitated by SEC Regulation NMS, that was co-authored by the industry. Regulation NMS has the valid purpose of establishing a consolidated national best bid and offer for each traded equity issue. But it also permits exchanges to provide customized market data feeds to certain customers. HFT was designed to take advantage of that privilege.

HFT computers, parked right next to the exchanges’ order-matching computers, pay the exchanges to receive order feed ahead of it being transmitted to network computers for the consolidated national best bid and offer. Called co-location, this placement permits HFT algorithms to reconstruct the national best bid and offer before it is publicly disseminated.

Fees paid for co-location account for a large chunk of the profits of the exchanges. All 14 U.S. exchanges are for-profit companies that the SEC allows to regulate themselves. Roughly 80 percent of NYSE volume comes from traders getting proprietary data feeds.

HFT firms have “cozy relationships with the exchanges,” said Sal Arnuk of Themis Trading, co-author of Broken Markets: How High-Frequency Trading and Predatory Practices on Wall Street Are Destroying Investor Confidence and Your Portfolio. Speaking at the recent Big Picture conference, he explained that exchanges used to be utilities. HFT firms even own of a couple of exchanges, BATS and Direct Edge.

Moreover, the exchanges have created special types of orders at the behest of HFT traders, such as “hide not slide” orders that are not displayed to other market participants. The exchanges accommodate these requests because they want volume. All U.S. exchanges pay for order flow.

The exchanges pay rebates for posted quotes and charge a smaller amount for orders filled—the maker-taker rebate system. The exchange usually keeps the spread—unless both sides of the trade are the same trader. So HFT algorithms hunt for rebates when prices are stable, buying and selling the shares at the same price and pocketing the spread on the rebate.

Gee, isn’t that a guaranteed profit from the rebate when a share is holding its price? Yes, absolutely. The maker-taker rebate guarantees riskless profits for HFT. The exchanges’ euphemism for this practice is “guaranteed economics,” according to Scott Patterson of The Wall Street Journal, author of Dark Pools: High Speed Traders, A.I. Bandits, and the Threat to the Global Financial System. European policymakers are considering eliminating the maker-taker rebate.

HFT is notorious for disappearing orders—toxic quotes. Bombarding the system with toxic quotes is how the algorithms drive up prices. “They add volume, not liquidity,” said Arnuk, who originally became interested in HFT when he noticed quotes vanishing.